Analytic Investment Management LLC

Invest Prudently

Main navigation

Investment Vehicles

True Cost of 401k and 403b

Due to continuous bleeding of many defined contribution retirement plans for the past 10 years, hidden fees in these plans becomes a hot topic in many financial publications. These discussions rarely address the fundamental problem with many retirement plans: lack of risk management and lack of investment performance. Nonetheless, disclosure of layers of hidden fees charged by all retirement plans probably can slow down the bleeding a bit.

How outrageous are these hidden fees after all? It is estimated that Bernie Madoff’s Ponzi scheme victims lost $20 to $30 billion over the period of 40+ years. With $3 to $4 trillion dollar of asset in defined contribution retirement plans today, each 1% hidden fees would cost retirement plan participants $30 to $40 billion dollars each year.

Edward Siedle, a former attorney with the SEC, says it very well in Forbes article 401ks: the America’s Biggest Investment Fraud Was Foreseen and Preventable.

The following 2008 video clips from Bloomberg has in-depth investigations on the hidden 401k fees.

(1) The part 1 of the video has an 401k plan expert review a John Hancock 401k plan participant’s account to show all hidden fees combined (wrap fees, soft dollars, revenue sharing, finder fees, shelf space, surrender charges, 12B-1 fees, etc) can be 3000% more than the 0.1% fee disclosed by the plan administrator. In many 401k plans Edward Siedle audits, he says investors are paying 3% to 5% hidden fees.

(2) The part 2 of the video reveals an union 403b plan with a shocking 12.17% hidden fee. It also shows a Walmart’s agreement with its 401k provider Merrill Lynch to withold fee information from employee in its 401k plan with $9.5 billion in asset.

(3) The third video clip has an expert examine the hidden cost of one of the largest 401k plans in the nation – Ford’s 401k plan administratored by Fidelity with $12 billion in asset. The video also have retirement plan specialists show some complicated charts demostrating even plan advisors can’t figure out where the fees go.

Yale Professor David F. Swensen’s words in page 294 of his 2005 book “Unconventional Success” is probably the best conclusion of all these hidden fees: “For the vast majority of mutual-fund investors, the future appears dim. Regulators identify abuses, deal superficially with the most high-profile issues, and move on to other matters. Meanwhile, the mutual-fund industry find new ways to place profits above investor interests. Even if the SEC eliminates pay-to-play revenue sharing, enforces fair-value pricing mechanisms and bans soft dollars, the mutual-fund industry, as it has from its beginning in 1924, will employ its endless creativity to find visible and less visible means to take advantage of individual investors.”

Fund Ownership of Mutual Fund Managers

Have you wondered why the mutual funds you owned in your 401k account continued to hold on to Lehman Brothers stock all the way from $65 on Jan 1, 2008 to $0 on September 15, 2008, even though there were plenty of time to get out at $50, $40, $30, or even $20, etc prior to it filed bankruptcy?

Morningstar recently published a great article on fund managers’ ownership of their own funds (https://news.morningstar.com/articlenet/article.aspx?id=372678), which may explain why most fund managers do not feel the pains fund shareholders are feeling:

“Fully 4,347 funds out of about 6,557 have at least one manager who isn’t investing in the fund. And of the 1,126 funds where there is just one manager, there is no manager ownership. On the plus side, 564 funds have at least one manager with more than $1 million at stake in the fund they run.”

4,347 funds out of about 6,557 is a shocking 66.29%! On the other hand, Warren E. Buffett, the most successful investor and money manager in the world, has invested almost all his money along with share holders of Berkshire Hathaway Inc.

Things to Consider Before Signing an Annuity Contract

We frequently see investors’ accounts stuck in inappropriate annuity contracts with insurance companies, facing the dilemma to choose between taking the huge surrender charge penalty or continuing to hold on until surrender period expires. Before signing an annuity contract, here are the tips that may help you avoid the most expensive investment mistake:

(1) Think twice before putting IRA accounts into annuity contracts. IRA accounts are tax deferred or tax free vehicles, is it necessary to put them into another tax deferred vehicles?

(2) Think twice if annuitization is mandatory in the annuity contract. By annuitization, annuitants are betting insurance companies under-estimate annuitants’ life expectancy. Are Insurance companies really that dumb?

(3) Variable annuity has very limited choice of investment options, typically limited to at most a few hundreds of mutual funds. If money is not in an annuity contract, 15,000 mutual funds, 1000 ETF’s, 10,000 stocks, real estates, separately managed accounts, and thousands of alternative investments are available to compete for your business. Which will be more cost effective?

(4) Annuity can be used as a tax deferred vehicle. But if you are paying 2% fee on 5% return, you are paying tax to insurance companies instead of IRS. Paying tax to IRS may not a bad thing after all if you really make money from investment.

(5) Annuity surrender charge is used to pay sales commission. Why not choose an annuity without surrender charge if you really want to buy a contract?

The Best Long Term Investing Strategy For Last Decade

As we enter into a new decade, it is worthwhile to look at the past decade to review which strategy worked best during the worst investment environment.

Value Line (www.valueline.com) is one of the most respected investment research firms, and its “Value Line Investment Survey” is the most trusted and used US stock market database, which is available from most of public libraries. Since June 30, 1961, Value Line created an “Value Line Composite Index” to cover around 1700 companies (out of 8000+ companies traded in US exchanges.) On February 1, 1988, Value Line began publishing the “Value Line Arithmetic Average” of the Composite Index, which can be found using symbol ^VAY on Yahoo finance page.

Unlike all the other static indices, Value Line Arithmetic index is interesting because from its web site, we know (1) it requires stocks in the index to have “Annual Net Income: at least $5-10 million preferably, but not necessarily growing.”; (2) “Vacancies constantly occur within our approximately 1,700 stock universe. Sometimes a company’s earnings will deteriorate to such a degree that we believe investors have lost interest. If that happens, we will discontinue coverage.”; (3) it re-balances very frequently since it is an arithmetic index.

Using Yahoo chart, let’s compare ^VAY with other popular US indices over the last 10 years.

^VAY is clearly on the top, with almost average annual 8% return without any leverage, followed by MDY (midcap 400 stocks), ^RUT (Russell smallcap 2000 stocks), ^DJI (Dow Jones large cap 30 stocks), ^GSPC (large cap SP 500 stocks), with ^IXIC (Nasdaq, around 2500+ stocks) last.

In the chart below, let’s compare ^VAY with some popular sectors and asset classes with long enough 10-year historical data. Once again, ^VAY is the top leader, followed by oil, real estate, retail, pharmaceutical, biotech, internet, with semiconductor last. Yahoo does not have long enough data on commodities index, but based on last 10-year GSCI futures data,  commodities performance is about the same as oil. In addition, based on inverse Dollar Index futures data, past 10-year return of buying foreign currencies is around 25% , which is not a bad investment since it does not lose money over the decade.

How does ^VAY compare with major emerging countries BRIC? The chart below shows only Brazil beats ^VAY for the past decade, with almost average 15% annual return, China ties with ^VAY for the 2nd place, followed by India, with Russia last. As one can see from the chart, BRIC countries are wildly volatile, it would be very difficult for any investor to invest in them without emotion.

Let’s also compare the most famous investors of the past decade in the following chart. ^VAY again is the clear leader, Warren Buffett’s BRK-A is the second, followed by Bill Nygren’s Oakmark Select Fund (OAKLX, 10-year 5-star fund), David Herro’s Oakmark International (OAKIX, 10-year 5-star fund, fund manager of the decade), Bill Gross’ Pimco Total Return (PTTRX, 10-year 5-star fund, fund manager of the decade), then last is William Danoff’s Fidelity Contrafund (FCNTX, 10-year 5-star fund).

The performance comparison may be a little bit surprised, but it makes absolute sense. Since companies traded in US exchanges pretty much cover any sector/country/asset, and ^VAY is designed to include only companies from all sector/country/asset making money at current market condition, it is natural for ^VAY to outperform the static indices and funds that does not sell losers.

Although Value Line database has been available for a long time, and for the past decade, the simple, boring, and labor intensive strategy has been outperforming any sector, country, or asset class, it is too easy for investors to get lost in all the news, hype, fear, and greed to adopt this strategy.

Of course, we are in a secular bear for the last decade, so how does ^VAY fare during the last secular bull market? Yahoo only has long enough historical data for a few indices, and following is the comparison since the inception for ^VAY. Clearly, during secular bull market from 1988 to 2000, earning does not matter that much. Just buy any stock that moves quickly will make money. Nasdaq is the top, with average 20% annual return, followed by Dow Jones 30 stocks, SP 500 stocks, with ^VAY comes in last, with annual return only 12%. However, the consistent advantage of ^VAY becomes clear once the secular bull market ends.

On February 1, 1988, Value Line began publishing the Value Line (Arithmetic) Average

Why mutual funds fail?

It is simply because the objectives of mutual fund companies and mutual fund investors are totally different.

The more asset mutual fund companies gather, the more money they make. On the other hand, mutual fund investors want investment performance and protection of their capital.

Most of mutual funds fail because of their assets are so big that they could not buy the best stocks and sell the losers.  The major stock holders of Bear Stearns and Lehman Brothers during 2008 financial crisis were all mutual funds, and they have no choice but held the falling stocks all the way to zero.

In the June 25, 1999 Business Week, Warren Buffett said: “If I was running $1 million today, or $10 million for that matter, I’d be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I’ve ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.”

No mutual fund companies want to cap their funds at $10 million, and many mutual funds are managing multi-billion dollars of retirement asset.

Yale Professor David F. Swensen, who is on President Barack Obama’s Economic Recovery Advisory Board, explains very well in page 294 of his 2005 book “Unconventional Success”: “For the vast majority of mutual-fund investors, the future appears dim. Regulators identify abuses, deal superficially with the most high-profile issues, and move on to other matters. Meanwhile, the mutual-fund industry find new ways to place profits above investor interests. Even if the SEC eliminates pay-to-play revenue sharing, enforces fair-value pricing mechanisms and bans soft dollars, the mutual-fund industry, as it has from its beginning in 1924, will employ its endless creativity to find visible and less visible means to take advantage of individual investors.”